Chinese reforms could trigger domino effect

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The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

What does China want? Sustained growth, and happier citizens. How will it get there? Through economic reform. It sounds simple enough.

But reform is a slippery word. While the problems facing China’s incoming new president Xi Jinping are well known, each potential fix depends on others, and most will meet with resistance. To succeed, Xi may need to push hard in three main areas: efficiency, innovation and the environment.

Better, not less

The common complaint that China invests too much isn’t necessarily true. While investment is a high 48 percent of GDP, according to the World Bank, that isn’t always bad in a half-urbanised country. The problem is rather that China invests ineffeciently. Banks don’t price credit properly, which means they have more incentive to lend to state-connected borrowers than private companies. Corruption is part of the efficiency problem, though it contributes to inequality as well.

The best solution would be to dethrone the large state banks, which hold more than half the stock of outstanding loans, and expose them to greater competition. That would involve letting interest rates float to more realistic levels, and improving governance so banks lend according to profit, not connections – even if eliminating corruption is a distant dream.

Vested interests are strong. Banks are big employers: the four largest employed 1.5 million people at the end of June. Reallocating credit might cause bad debts, as some borrowers find themselves unable to roll over their loans. But if depositors and investors got better returns, and consumers and companies more equal access to credit, such reforms should enjoy broad support.

The second big challenge is innovation. Being able to invent and adapt is the difference between a middle-income country reliant on technologies and services from abroad, and a wealthy one that makes its own fortune. A fully functioning legal system that protects ideas would help, though that is still a long way off.

One way to aid innovation is to reduce the dominance of state-owned enterprises. State ownership isn’t necessarily bad, but protected industries tend to try less hard. Opening sectors like telecoms or energy to competition would increase efficiency, and give them an incentive to be more creative. Again, vested interests are the problem. Companies are powerful and well connected, and local governments reluctant to repeat the massive lay-offs of the 1990s.

Finally, there’s the environment. Pollution makes citizens angry, as recent protests in Ningbo showed, while guzzling scarce resources compromises future growth. One solution would be to start pricing resources like water and petrol properly, so profligate industrial users have a stronger incentive to change their ways.

Politicians, though, tend to prefer leaving environmental concerns to future generations. Besides, cleanliness and supply aren’t always compatible: coal is abundant but dirty; drilling cleaner shale gas uses lots of water. China’s best bet is to invest heavily in technologies that allow it to create clean, plentiful energy – but that in turn depends on reforms that nurture innovation and efficiency.

A question of capital

In China, one reform often requires another. Get banks to allocate credit properly and they might need a bailout when debts go bad. Strengthen the legal system and it might compromise the supremacy of the party. Urbanisation is a major driver of sustainable growth, but growth in city-dwellers puts pressure on local government budgets. No single problem has a single solution.

That may be why President Hu Jintao’s outgoing government, which presided over impressive growth and stability for ten years, has achieved little lasting reform. Anachronisms like the one-child policy, and the “hukou” identity card system, which traps economic migrants in low-paid labour rather than comfortable consumerism, have yet to be swept away.

Xi might be different. What matters isn’t just whether he wants reform, but whether he can amass the political credibility to overcome opposition. That will take time to build up. Xi will have two former presidents, Hu Jintao and Jiang Zemin, and other party seniors looking over his shoulder. Consolidating his power will take many months, at best.

The best hope is that Xi is less like Hu, and more like Deng Xiaoping, the Chinese leader most associated with successful reforms. When early opening up led to widespread corruption, Deng forged ahead anyway, remarking that “when you open the door, flies will get in”. Then, as now, the best tools for economic reform in China are a way with words, and a hard head.

Author Profile

John Foley is Reuters Breakingviews' editor for Europe, the Middle East and Africa. He relocated from Beijing in July 2015. John established Breakingviews’ Hong Kong bureau in 2009, and has written on China’s economy and financial system, mergers and acquisitions, capital markets and consumer goods. Follow John on Twitter @johnsfoley